China: Searching for a Soft Landing
Andy Xie (Hong Kong)
Still Overheated
The Chinese economy remains overheated 17 months after the first tightening move. Both the production and investment data suggest that the economy is still growing substantially above trend. Overheating in China is not about inflation, which occurs due to overinvestment (overinvestment eventually leads to deflation – the more inflation occurs today, the more deflation will occur tomorrow).
Overheating in China is about excessive investment based on unrealistic expectation of future profits. When everyone is increasing investment, it creates inflationary pressure in the short term and boosts profits for those businesses that supply materials for investment. The higher profitability due to inflation validates the optimism and encourages more investment. The process ends either when interest rates rise to keep inflation down or when capacity growth outstrips investment demand.
Excess capacity is already a serious challenge in automobiles, steel, chemicals and electronics. The continuing optimism over the property market is the last remaining prop sustaining investment enthusiasm. If left unchecked, I think the excess capacity situation will continue to worsen, causing deflation and another wave of bad debts. Easy monetary policy leads to inflation today, but deflation tomorrow.
A Soft Landing Is Difficult to Achieve but Still Possible
It is more difficult now to achieve a soft landing as the investment excess is much greater than one year ago – i.e., it needs more demand to satisfy the existing capacity to achieve a soft landing. A soft landing is still possible, but requires creative policy actions by the Chinese government and some luck, in my view.
The most important external factors are the dollar and the US economy. The worst combination for China would be a strong dollar and a weak US economy. The best combination would be a stable dollar and a strong US economy. The latter would cool hot money flow into China but keep China’s exports relatively strong. This scenario would give China the most room to achieve a soft landing.
China can influence the external environment. By keeping the exchange rate stable, China can help to stabilize the dollar. While the US economy may continue to slow down due to its large trade and fiscal deficits, a stable dollar would give Mr. Greenspan the room to achieve a soft landing. A soft landing of the US economy is a necessary pre-condition for China to achieve a soft landing, in my view. This is why I believe that China will keep its currency stable in 2005.
A favorable external environment is necessary for China to achieve a soft landing, but more is needed. I believe the situation requires an active policy on domestic demand. The best domestic policy would be to boost consumption to support a soft landing. The worst would be to boost investment to engineer a soft landing. Sustaining investment growth during economic deceleration adds further excess capacity and stores up more deflationary pressure for the future. The soft landing would be achieved by creating more bad debts.
A Few Options to Boost Consumption
China’s consumption has been a passive variable, merely responding to income created by exports and investment. It was encouraging to see retail sales remaining strong towards the end of 2004. However, the housing boom could be behind this. Sales of new residential properties rose by one-third in value last year, generating substantial retail sales associated with interior decoration. Rising property prices may also have a significant wealth effect on consumption in other areas. It is still too early to determine whether retail sales can remain strong beyond the housing boom.
The fundamental barriers to consumption strength are: (1) low household wealth; (2) low labor income; and (3) low returns on investment.
Returning wealth to the population would be my first choice to boost consumption (see ‘China Needs to Spread Its Wealth’, Financial Times, April 15, 2004). During the socialist planning period, Chinese households had no opportunities to accumulate wealth, but also had their retirement expenses covered by the state. As China has been migrating to a market economy, households must accumulate wealth faster than income growth to deal with new expenses (e.g., retirement, healthcare, and education). This is a structural drag on China’s consumption.
Land and state monopolies are the most valuable assets under government control and could be worth 100% of GDP, on our estimates. I believe China needs to give this wealth back to the population to develop a consumption-led economy. The process of distributing this wealth may be complicated, but, if the government were to embrace the principle, it would increase consumer confidence and have a meaningful effect on consumption.
Second, China could raise the minimum wage in the coastal regions. The ample labor supply from inland has kept wages very low in the coastal export provinces. Indeed, wages have hardly changed in the past ten years despite the fourfold increase in exports. Recently, inflation has been eroding purchasing power such that factory workers’ living standards have likely declined in the past two years. I think China can and should raise the minimum wage in the coastal provinces of Guangdong, Fujian, Zhejiang, Shanghai and Jiangsu to RMB1,000 per month. This level is much higher than the minimum wages of RMB500-600 prevailing in these provinces now. To minimize the shock, the increase could be phased in over three years.
To ensure that the minimum wage is enforced, China could set up courts under central government control to settle labor disputes. Because local governments want to increase GDP and often collude with businesses to keep wages down, they cannot be relied upon to enforce the minimum wage.
Raising the minimum wage is far better than revaluing the currency. A currency revaluation would only increase the value of bank deposits that a small minority controls. However, it would cause export businesses to squeeze Chinese workers further. Raising the minimum wage may have a similar effect as revaluation on cooling exports, but would benefit those who need money badly.
A higher minimum wage along the coast would also push economic development inland without cutting China’s overall competitiveness. Lack of protection for migrant workers is at the heart of labor disputes in China today, because migrant workers have little political influence over their host governments. If factories can migrate to where workers are, labor disputes should decrease.
Third, raising interest rates can improve consumption. Despite rapid economic growth, interest rates on bank deposits – the most important item in household wealth – remain extremely low. The one-year savings deposit rate is just 2.25%. Extremely low interest rates subsidize investment with household savings. China is facing overinvestment. It makes sense to decrease this subsidy and return some money to the populace.
Moreover, I think China should keep interest rates relatively high even when deflation returns. Deflation is a manifestation of excess investment. Keeping interest rates low during deflation only encourages more investment and prolongs deflation.
Bottom Line
Overinvestment, weak consumption and over-dependence on exports are the defining characteristics of China’s economy at present. These factors make the economy prone to speculative bubbles, as evidenced by the current situation. I believe China can use structural reforms to increase its chance of achieving a soft landing and improve its overall economic efficiency at the same time.
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